Credit: Don Feldman
The election of Joe Biden on November 2, 2020 created one of the great tax-planning stampedes of most practitioners’ lifetimes. Biden had run on a platform of increasing capital gains rates from 20% to 40% on gains more than $1 million. He also planned to reduce the estate and gift tax exclusion from the current level of $11 million+ per person to $3.5 million. In November 2020, control of the Senate was still uncertain due to the runoffs for the two Georgia seats scheduled for January 5, 2021. But Chuck Schumer, the Democratic Senate leader famously promised “Now we take Georgia, then we change the World.” It was thought that any 2021 tax bill would make changes retroactive to January 1, 2021.
$1 million sounds like a lot of capital gains (and it is). For business owners selling their businesses that they had spent a lifetime building, a gain of three or four million is not unusual. Taking a 40% federal tax slice would mean that a large amount of that lifetime of effort would go up in smoke. I personally was working with two such businesses for which a Letter of Intent had been signed in 2020 but were not going to close until 2021.
Similarly, the reduction in the per person estate and gift tax exclusion (currently $11.7 million) to $3.5 million would overnight create a multi-million-dollar tax liability. Many wealthy families who thought they were immune from estate and gift tax were affected.
The demand for tax planning to avert these results was overwhelming. An army of tax lawyers and accountants mustered their troops and marched into battle.
What Actions Were Taken?
To avert the capital gains hit on the sale of businesses (and certain other assets) that were to close in 2021, tax planners deployed an irrevocable trust by which the business was sold to the trust in 2020 to lock in the gains in 2020 at the current 20% tax rate. When the business was then sold to a third-party buyer in 2021, no or little gain would be recognized because the 2020 sale to the trust had increased the basis of the assets to fair market value. The downside to this technique was that the tax had to be paid a year in advance – April 2021 rather than April 2022 – but this seemed like a small price to pay to save 20% of the gain above $1 million.
Spousal Lifetime Access Trust (SLAT)
A common planning technique to use the $11.7 million 2020 gift tax exclusion is a so-called Spousal Lifetime Access Trust (SLAT). Again, the idea was to make a large gift to an irrevocable trust of which the donor’s spouse was the beneficiary during his/her lifetime with children or grandchildren as remainder beneficiaries. Reciprocal SLATs could be used so that each spouse could give to the other up to about $11 million, thereby using the bulk of each spouse’s lifetime gift exclusion. By doing this, the spouse(s) could exclude the gifted amount from his/her estate. In addition, the spouse would receive some benefit from the assets because the non-donor spouse could receive lifetime distributions from the trust.
How Does This Planning Look A Year Later?
Well, the Democrats did take Georgia, but they have not (yet) changed the world of taxes. The plan to raise capital gain and estate/gift taxes seems to have foundered on the rock of the Democrats too-narrow majorities in Congress. At this writing, the chances for significant capital gains and estate/gift tax increases seem remote.
So, in retrospect, what was the cost of these planning efforts (apart from the not insignificant legal and accounting fees)? In the case of the early sale of business assets to an irrevocable trust, the only tangible cost was paying the capital gains tax a year early. The time value of money is something, but in the super low-interest rate environment of late 2020, this amounted to no more than 2%-3% of the tax. Would you be willing to pay 2% to avoid a possible 20% tax hit?
In the case of SLATs, there is no tangible cost (again apart from professional fees), but the result is a more complex financial situation, with the need for annual trust tax returns for the newly created irrevocable trust(s). However, there is a possible silver lining. The current estate/gift tax exclusion regime is scheduled to expire after 2025. At which point the exclusion will revert to $5 million adjusted for inflation. So, it is quite possible this type of SLAT planning will still be helpful, even if done a few years earlier than necessary.
For some of us, it seems incredible that after the tax planning tsunami of late 2020, no significant tax changes have yet come to pass. But it serves to remind us that no one’s crystal ball is perfect. When engaging in this sort of planning you must consider the possible costs as well as the upside.
Don Feldman is the founder of Keystone Business Transitions, LLC, a Lancaster, PA firm devoted to helping business owners smoothly exit their companies. He has been a CPA for over 25 years and a valuation professional for 20 years. For the last 15 years, Don’s practice has focused on succession and exit planning, including transfers of business interests.